The founders of European Economic and Monetary Union
(EMU) believed that their creation was irreversible. For former German
Chancellor Helmut Kohl, the euro was the glue that would hold
France and Germany together in permanent peace. In the key French
referendum of September 1992, supporters of the Maastricht
Treaty on European Union portrayed EMU as essential to preventing
the powerful new united Germany from ever taking a dangerous
unilateralist road. If monetary union were in fact no more
than a 10-year experimental trial that could be terminated without
huge cost, then these grand political aims were flimsy at best.
Accordingly, all the official and legal
texts portray the euro as an egg that cannot
be unscrambled. That image is false.
The euro is more like a solution that can
be distilled back into its component currencies.
There are significant costs associated
with the distillation process. But
they are not so high as to sustain monetary
union under all conceivable circumstances.
The various scenarios in which
European monetary union shrinks or
disintegrates, which I shall describe
more fully later, are striking for their
practicality.
None of these procedures, of course,
can be found in the Maastricht Treaty.
But much history would be extinguished
if treaties were never broken or re-negotiated.
From the perspective of the euro's
fifth birthday in early 2004, it is highly
plausible that there will be demands
for a re-negotiation of the Treaty before
its tenth birthday. Threatened exit is
one bargaining tactic of the country or
countries demanding reform. In the
case of Germany in particular, the threat
is a very powerful weapon. Monetary
union would probably not survive a
German pull-out. The Netherlands, Belgium
and Luxembourg have historically
been attached to a German monetary
anchor and would almost certainly decide
to follow Germany out of a truncated
union.
Germany has much reason to be disillusioned
with the functioning of EMU
to date, even though it played a lead role
in its design. During the period of creation,
Germany had tremendous influence
on the design process. France was
the lead supplicant, begging Germany to
give up the Deutsche mark and monetary
hegemony in Europe. German negotiators
understandably expected much in
return. In particular, they insisted that
the European Central Bank (ECB) adopt
the stability framework of the Bundesbank.
They totally failed to imagine that
the German economy could enter a
Japanese-style lost decade, from which
the only exit might be zero interest rates
and currency devaluation. Once in
union these conditions for a return to
German economic prosperity could be
impossible to achieve.
There is no reason to expect German
voters to meekly resign themselves to the
errors of past policy makers. If German
economic performance does not improve,
then at least one mainstream
party will surely seize the opportunity to
win votes by demanding EMU reform.
The more aloof and incompetent the
conduct of the ECB, the more likely will
this become. Suppose, for example, that
the euro zone were to move into a deflationary
stagnation which could be attributed
plausibly to the ECB's policy
errors during 2001-2004. Attacks on the
ECB and reform proposals could then
become themes for political debate as
early as the German Bundestag elections
due in the autumn of 2006.What would
be in the agenda for reform?
Germany could insist that ECB policy
makers place a larger focus on divergent
business cycles within the euro
zone. This demand is justified by the underlying
economics of EMU. There are
important spillovers from Germany onto
the other countries. In particular, Germany's
present process of extracting itself
from stagnation by enduring a fall in
its prices relative to other euro members
(meaning an increase in the competitiveness
of German products) has limits.
The other countries would ultimately
experience deflationary conditions in
their export industries.
The ECB should take this knock-on
effect into account when deciding on the
appropriate present level of policy determined
interest rates. The German
government could act as a catalyst to
pre-emptive monetary policy by installing
a boldly charismatic monetary
expert as head of the Bundesbank, who
would exert much influence in the
boardrooms of the ECB. (Perhaps the recent
appointment of Professor Axel
Weber as Bundesbank President in place
of Mr. Ernst Welteke could prove to be
just such a step). Given powerful enough
domestic support, the new Bundesbank
President could also show disrespect to
the secrecy conventions instituted under
Wim Duisenberg, the ECB's first president.
These have fortified the undemocratic
features of the Bank, making it remote
from the general European public.
It would take only one powerful central
banker to defy ECB secrecy to bring
about rapid reform in this area. This
would include not just open voting and
full minutes of meetings but an obligation
for ECB council members to testify,
on a rotating basis, before national parliaments,
which have the ultimate power
of censure over the ECB. They, not the
European Parliament, can initiate or
sanction changes in the Treaty of Maastricht
or unilateral exits from EMU.
The various national electorates
might feel less alienated from the proceedings
around the ECB council table if
they could see evidence of their own
central bank president acting effectively.
German voters would be impressed if
the Bundesbank President were arguing
eloquently and forcefully that the ECB
should set its inflation target in a way to
take account of the severe economic
conditions in Germany.
Revamping the inflation-targeting
process would be central to reform. In its
early years, the ECB viewed a highly simplistic
and strict inflation targeting system
as essential to winning confidence in
the new money. The ECB, unlike the
Bundesbank, enjoyed no reservoir of
public trust. But now the inflexible pursuit
of price stability (interpreted as an
annual inflation rate of two percent or
very slightly less) is a handicap to economic
recovery. Ideally, the ECB, in consultation
with the Finance Ministers of
the Eurogroup, would determine the appropriate
medium-term target range for
low inflation, given current economic
circumstances in the euro zone and the
world outside.
Take, for example, a situation of
wide divergence between the degrees of
slack in the member economies, where
large changes in relative price levels
could advance overall prosperity. In such
a case, the ECB should adopt a somewhat
higher and broader inflation target
range than when business cycle conditions
were largely synchronous. Substantial
changes in price relationships would
require an actual fall in prices in some
countries (those, in our example, where
the degree of slack was large) if the overall
inflation target for the whole union
were set very low. Normal rigidities,
however, mean that it is painful economically
to achieve falls in wages and prices.
As another illustration of the benefits
of flexibility in inflation targeting,
take the present situation, in which the
country with the largest savings deficit in
the world, the United States, has abnormally
low real interest rates. It follows
that the countries in savings surplus
including the euro zone should have
even negative real rates. Otherwise private
capital will not flow out of the savings
surplus countries to the United
States and their currencies, if freely floating,
will enter an upward spiral.
The inflation target in the euro zone
should be adjusted flexibly so as to allow
real rates there to fall. The present and
continuing morbid strength of the euro
has been in considerable part due to the
ECB setting its rigidly defined aim of
price level stability in a spirit of splendid
isolation. It is hard for those ECB officials,
including President Jean-Claude
Trichet, who saw monetary union as a
way of gaining independence from dollar
hegemony, to admit that even now
their monetary policy should bend before
U.S. economic realities.
EU Finance Ministers have not used
their powers under the Maastricht Treaty
to override the in built isolationism of
the ECB policy makers in Frankfurt. The
Ministers could have taken the lead on
currency market intervention, initiating
plans (via the formal intermediation of
the European Commission) for massive
joint dollar purchases by their respective
central banks, financed by government
debt issuance, which would be implemented
unless the ECB eased its monetary
policy.
Hopefully the Ministers will be less
tame if events prove that ECB policy
makers have failed their publics miserably
by allowing deflation to take hold.
(The present spike in world oil prices
does not diminish that risk in that the
primary impact is to dampen aggregate
demand). A coherent reform package
should include the suspension of the
ECB's independence from governments
under conditions of deflation. An economy
cannot be extracted from a deflation
trap by a central bank on its own.
No reform would be complete without
an overhaul of the European Stability
and Growth Pact. An unconventional way
forward here would be to make an explicit
reference in a revised Maastricht Treaty, or
in the new European constitution, to the
possibility of withdrawal from monetary
union. Then fiscal policy in each member
country would be constrained by the possible
threat of bankruptcy, which would
involve an emergency pull-out from EMU
and the activation of a national money
printing press. So long as the legal fiction
persists that monetary union is unbreakable,
investors understandably question
the seriousness of the "no bail-out" rule,
which bars the ECB from lending to governments
in crisis.
There is a common interest among
member countries in avoiding the external
costs of a default crisis. These would
be greatest in the case of a forced withdrawal
of Germany. And so some type of
Stability Pact is ultimately needed to restrain
German fiscal policy. Here lies the
central paradox of monetary union. The
French founders of EMU believed that it
would give France more influence and
Germany less than the old European
currency regime. But as it has turned
out, Germany is now in a unique position
to pose existential risks for the euro.
France has gained no tangible sway
over European monetary policy. Arguably,
Paris has increased its influence
on policy-making in the Group of Seven
leading nations. This is illustrated by the
lead role of Mr. Trichet, as ECB President,
in articulating traditional concerns
of the French economic policy elite about
the dangers of U.S. deficits for the world
economy. But his strategy of joining
forces with U.S. mercantilists against the
Asian dollar bloc has so far brought tears
not celebration for French industry, now
weighed down by a super-strong euro.
Monetary powerlessness could eventually
be a source of discontent in
France. But it is difficult to imagine the
pro-EMU center ground in French politics
losing its strategic hold. The Netherlands
and the UK are more plausible
direct or indirect drivers of EMU reform.
The Netherlands has lost much
from monetary union. Its real estate
boom and bust has brought severe problems
of economic adjustment that could
have been solved less painfully with an
independent monetary policy and currency
flexibility. What has the Netherlands
achieved in return for sacrificing
those options?
It has acquired a seat on the board of
the ECB, and the first ECB president was
Dutch. But the Netherlands has foregone
the prestige and economic benefits of
marketing its own small currency brand
to compete with the Swiss franc. The disadvantages
of a small currency, so heavily
emphasized in the literature promoting
monetary union, have diminished with
the development of technologies that
make possible dual pricing and multiple
currency accounts. A threatened or actual
withdrawal of the Netherlands would not
trigger a general dissolution of EMU, but
it could be a wake-up call to the need for
democratic reform.
The UK's power to bring change depends
on how far present euro members
see political and economic advantages
from British accession. London could
make any eventual bid contingent on the
calling of an intergovernmental conference
to press a reform agenda. The actual
mechanics of such an approach,
however, are dubious. Which of the
other countries would take London seriously
before a Yes to the euro had been
obtained in a British referendum? But if
the referendum were held before reform,
the political opposition to the euro in
the UK would make much of the imperfections
admitted by the government
pressing for entry.
The alternative to reform is a rising
possibility of separation or dissolution.
In particular, a small or medium-sized
country could make an exit either
abruptly or by stages over several years.
The staged withdrawal would involve relaunching
a national currency which at
first would be fully convertible on a 1:1
basis into the euro. The government of
the departing country would breathe life
into its new money by adopting it for its
own use in expenditure and taxation.
In a second stage the new money
would be floated within fixed limits
against the euro and the government
would expand the area of its mandatory
use (for example to real estate rental
agreements, public utility pricing and
most wage contracts). In the private sector,
computer technology could easily
handle dual pricing and payments allowing
retail prices to be quoted in both
euros and the new money. In the final
stage, a fully-fledged independent and
freely floating national money would
emerge.
To make a rapid exit, the government
would decree a re-denomination
of resident deposits and loans with the
domestic banking system into the new
national money. During a transitional
period, until new banknotes were
printed, deposits in the new money
could not be converted on a 1:1 basis
into currency. Euro bills and coins would
remain the only form of currency and
would trade at a variable rate against the
new money in line with its exchange
rate against the euro. In the retail economy,
euro banknotes would continue to
be used and dual pricing would be the
rule. Advanced technology should allow
banks to operate a system of variable
charges or credits (depending on the exchange
rate) on withdrawals of euro cash
from automatic teller machines. Such
withdrawals would be debited from current
accounts in the new money.
Unlike gradual separation, the rapid
exit scenario might well entail substantial
windfall losses in the banking industry,
owing to a mismatch between the
totals of resident deposits and loans. As
an illustration, take the case of a hypothetical
Dutch withdrawal. If there were
a large excess of resident euro deposits
over euro loans to residents, the forced
redenomination of these deposits into a
reincarnated guilder that started its new
life at a discount to the euro would inflict
exchange losses on the Dutch banks.
The government would have to provide
partial compensation in extreme cases in
order to avert a banking crisis, triggered
by a large write-down of bank capital.
But the government would have the advantage
of being able to effect an immediate
devaluation or revaluation of the
new currency and thus achieve a quick
exit from either deflationary or inflationary
conditions in the euro zone.
Both rapid and staged exits would
ideally occur within the context of cooperation
between the departing country
and those remaining in the union. In
particular, the departing country would
agree to redeem the euro banknotes
which seeped back to the truncated euro
zone. This seeping back process would
stem from residents in the departing
country selling euro bills in exchange for
the new national banknotes. The sold
euro bills would swell the total deposits
that banks in the now shrunken euro
area would hold with the ECB. A redemption
agreement would provide for
the government of the departing country
to buy back the euro bills that used to
circulate on its territory. Otherwise the
ECB would have to mop these up by selling
government bonds from its portfolio,
losing important interest income in
the process, so as to avoid an inflationary
increase in the money supply over the
territory of the truncated zone.
Cooperation would be vital in the
case of a general dissolution of EMU. In
this case, each country would re-denominate
resident euro deposits and loans
into national currency units. Non-resident
positions would be converted into a
reincarnated European currency unit, or
ECU (a basket currency made up of the
new national monies weighted according
to economic size). Euro bills would be
convertible 1:1 into ECU-denominated
deposits at a member central bank. Each
of the central banks would bear its share
of responsibility for redeeming these on
demand, delivering their respective national
monies in due proportion against
ECU deposits presented for conversion
into national components.
The technical hurdles in the way of
dissolution are no greater than for the
original introduction of the euro. Until
the new bills in national money were introduced,
euro bills would continue to
serve as the main cash medium of exchange.
Their day-to-day conversion
rate with respect to any of the new national
monies would be in line with the
relevant ECU exchange rate. In effect
euro bills would have become ECU bills,
without there being any need to print
these. The main technical challenge
would be to provide for the debiting of
euro bills withdrawn from automatic
teller machines at the current ECU exchange
against bank deposits in the respective
new national money. And there
would be the inconvenience during the
interim period (until national bills become
available) of dual pricing in the retail
economy. One price would be for
settlement in the new national money,
the other for settlement by cash in the
form of euro bills.
General dissolution would be an unwelcome
development for several governments
in the new member states
which joined the European Union in
May 2004. Adoption of the euro as soon
as possible was to be the fast road towards
gaining the benefits of access to
highly developed money and capital
markets. It is possible that a few past
members of EMU would enter into discussions
about a shrunken union that
the new member states could join, subject
to satisfying the specified eligibility
conditions. But it is difficult to imagine
this becoming reality without the participation
of Germany. And there could be
political qualms in Central and Eastern
Europe about submitting to a new German
monetary hegemony. The present
supranational European monetary order
is much more acceptable, even though it
suffers from a deep democratic deficit.
The lack of democracy and of
progress toward European political integration,
however, strengthens the conclusion
that the euro zone may not be
able to hold together. Many large currency
areas, including the United States,
would long ago have splintered into regional
currency areas if it had not been
for the unifying force of political federation
and of widespread respect for the
central monetary authority. In the case
of Europe, political idealism may have
originally persuaded citizens to vote for
a monetary union of dubious economic
benefit. But they will not continue to approve
a currency union that demonstrably
inflicts overall harm on their
economies as the political ideal fades
away. National self-interest will surely reassert
itself. If that happens first in Germany,
the life expectancy of European
monetary union will be short.
Brendan Brown is director and head of research at Tokyo-Mitsubishi International
plc in London and author of EURO ON TRIAL: to reform or split up (Palgrave,
March 2004). He is the author
of many previous books on international finance, including The Yo-Yo Yen (Palgrave),
The Flight of International Capital (Routledge) and Monetary Chaos in Europe
(Routledge). He is a regular
columnist in the Nihon Keizai Shimbun. Based in London, he provides advice on
international
investment strategy to a wide range of European and Japanese clients.
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